Can the concept of dollar-cost averaging (DCA) help prevent nervousness in investors? (I think so.) But what is DCA and is it a viable investment strategy? If you are a seasoned investor with a large lump sum from a 401(k) rollover, property sale, inheritance, or other source, you are likely to think of DCA as second-rate or lower-performing strategy, which it in fact may be. But if you are a beginning or less experienced investor who has just a bit to invest each month ($25 to $100), then the DCA concept may help you feel comfortable in starting to invest and let you relax during market fluctuations.

Here’s a short definition of dollar-cost averaging from Kiplinger’s glossary: “a program of investing a set amount on a regular schedule regardless of the price of the shares at the time.”

As an illustration, suppose you decided to buy Janus Venture (JAVTX, a no-load, small cap growth mutual fund with a 4-star Morningstar rating considered high risk with above average returns) in September 2006, invest $100 per month for 13 consecutive months (Sep 2006-Sep 2007), and purchase shares sometime around the 20th of each month. I used MSN Money charts to find prices on specific dates in the past year.

By September 2007, you’ll have invested $1,300, purchased 19.46 shares at an average cost of $66.79, and have an investment valued at $1393; you'll have earned a return of 7.15% for this period. But, if you had invested $1,300 as a lump sum in September 2006, you would now have $1,549 and grown your investment by 19.15%. In this scenario, the DCA strategy is the lower-performing one. But, I am proposing that if you are a beginning investor and you did not have $1,300 in September 2006 but rather $100/month in investable income, then you are $1393 richer and now positioned for further growth (hopefully). Here's a spreadsheet with the monthly prices and my calculations.

It is argued, and convincingly to me now that I consider it, that DCA as a strategy for lump-sum investing is almost always not the best strategy because the market in general and individual investments in particular (no-load mutual funds in this case) rise over time. So, more often than not, the sooner you can make an investment, the better. In "The costly myth of dollar-cost averaging," Timothy Middleton of MSN Money states that dollar-cost averaging is not the same as investing regularly scheduled amounts but rather positions it as an alternative to investing a lump-sum amount. He mentions that this strategy is often pitched to nervous investors. If you define DCA as an alternative to lump-sum investing as Wikipedia does, consistent with Mr. Middleton's perspective, then DCA is usually going to deliver lower-performing results. Oddly, though, I had only heard of DCA in my finance classes in college and have never been pitched its value by investment salespersons (maybe I'm not a nervous investor).

Trent of The Simple Dollar writes about Dollar-Cost Averaging and uses a definition similar to Kiplinger.com and my understanding: "Dollar cost averaging is an investment philosophy in which you buy a particular investment regularly over a period of time with an equal amount of cash each time."

As for me and my portfolio, I didn’t start investing as a lump-sum holder but rather as an eager 20-something who, when I was able to start saving, figured that investing, over time, even small amounts, would reap benefits. My strategy wasn’t particularly sophisticated (just disciplined), beginning with a dividend reinvestment plan (DRIP), progressing to purchases of mutual funds, and then, much later, to individual stock investing. In my DRIP-and-mutual-funds-only days, shares were purchased when the prices were low and high. Here's what I learned:

Prices go up and down;

Sometimes you buy shares at attractive prices and sometimes you buy shares at not-so-attractive prices;

The value of your investments may decline during market corrections or investment-specific slumps;

Over time, the value of sound investments will rise.

So, DCA helped me get used to the idea that investing doesn't always provide a smooth ride but can deliver great returns in the long run. It's saved me from becoming a nervous investor (or at least one who doesn’t act rashly and sell during market lows) despite day-to-day fluctuations in my net worth.

Disclosure: I do not own Janus Venture, which is closed to new investors.

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A few thing of note. First, one of the beauties of DCA is that you buy more shares when prices are low and fewer when prices are high. So you get a little extra "leverage" that way.

I wouldn't be so quick to write off DCA in lump sum situations. Depending on the volatility of the investment it could make really good sense. First, take the money and put it into a money market fund, or something similar.

Then, if you wish to invest in individual stocks, or even market index funds. If you were to invest all the money at once, what are the chances that the market will immediately go up and never come back down to that level again? Probably small. If it does you will be happy that you invested at least some of your money.

On the other hand, if the market goes down, you would be happy that you didn't. DCA is really just a nice way to reduce volatility. It doesn't maximize returns. In the most likely event of prices fluctuating around some point, you end up with more shares because you bought more in the lows.

It's easy to point to periods when you would have wanted to be all in and just as easy to point to periods when you would wish that you weren't.

Thanks to Decision Strategist and Tony for contributing to the DCA conversation. When I started researching DCA to add to my thoughts, I was surprised to see so many negative perspectives on DCA. I didn't really think of it as a comprehensive strategy but as a way of seeing that market volatility is not always such a bad thing or at least a way of taking the edge (risk) off of investing.